What is Tax Basis?

Rebecca A. Casarez, CPA

Rebecca A. Casarez, CPA

what is tax basis-ProAdvisor CPA

Tax Basis is the value of ownership in a business (or any other asset, like equipment or shares of stock). Tax Basis is different (or could be) than Book Basis, and a big reason is that the Internal Revenue Code (IRC) treats transactions differently for tax purposes than GAAP does for financial reporting purposes.

Tax Basis determines how much Income Tax, Penalties, and Capital Gains (Losses) and other tax treatments are applied to each owner, especially when it comes to pass through entities (S-Corporations, LLCs, Partnerships etc…).

What is Book Basis:

In financial accounting, businesses must follow accrual accounting, GAAP rules with little exception, when preparing externally used Financial Statements. Likewise, businesses must follow the Internal Revenue Code (IRC) when preparing Income Tax returns. There are also various state and county rules that businesses must follow when reporting business activity. I know, I know, you are probably bored and terrified at the same time. Although not exactly exciting material, OR the reason why you wanted to be your own boss and start your own company, understanding your basis and the fundamentals are crucial to your success as a business owner.

So what does Basis Mean:

In order for you to understand what Basis is, we need to go back to the beginning… Literally, the beginning of starting a business in the garage with your friends, starting your own company, when you buy stock in a company and so on. The beginning of OWNERSHIP in a company.

Every business has “owners” to the company, which can be shown as partners, equity owners, shareholders etc… depending on the type of business formed (corp, partnership, sole proprietorship), number of “owners” and preference. For instance, a corporation has “shareholders”, each purchasing common stock to get the rights to their portion of the “company pie”, so to speak. This is more easily understood since buying shares of stock in the open market is common practice. However, when forming a partnership, each partner needs to contribute something of value in order to have earned their rights to their percentage of that partnership entity.

So, in order to get the rights of owning their share of  that “pie”, you must give something up for it (usually CASH, but could be property, stock, land, patents and so on…). For our purposes of general explanation, we assume that CASH is given up for the ownership rights and that the Fair Value of the CASH is equal to the trading value of the ownership being issued.

When an “owner” provides CASH (or other property) in exchange for their portion of the company, it is called contributing capital (or property) to the company. This is shown on the Balance Sheet, in the Equity section. (refer to Balance Sheet article) The value assigned to the capital contribution is called BASIS and is the starting point for both financial and tax methods of accounting.

Basis Overview:

“Basis” is an accounting term to describe an owners invested interest in a company – which starts with what each “OWNER” contributed to buy/earn their shares of the company.. Simply put, Basis is the individual measurement an owner (Partner or Shareholder) recognizes as THEIR portion or share to the company’s annual PROFITS, ASSETS and/or OBLIGATIONS (LIABILITIES).

BASIS increases or decreases when any one of these happens:

  1. When the Business (or Asset) has PROFITS (LOSSES)
  2. When the Business (or Asset) DISTRIBUTES (DIVIDENDS) directly to the owners
  3. When the Business (or Asset) is SOLD (either in whole or in segments).

Book Basis is a financial accounting term and Tax Basis is what is reflected on the company’s and/or individual income tax returns. Basis (both Book and Tax) change based on each year’s Profits (Losses) and/or Distributions (Dividends). This means that next year’s BASIS could be different than this year’s BASIS.

Simple Example:

Peter and Paul form a partnership: P&P Plumbing, LLC. Peter contributed (gave) $80,000 to P&P Plumbing, and Paul gave $20,000. This means that P&P Plumbing now has $100,000 in the Bank as an asset and $100,000 in Owner’s Contribution in Equity.

This also means that Peter OWNS 80% and Paul OWNS 20% of P&P Plumbing,LLC. These percentages and amounts are what will be used to apply both financial and tax accounting rules when the LLC conducts business that impacts the Equity of the company.

In year one, the company had $100,000 in Net Income (Profits). Since this is an LLC, a pass through entity, the Company itself does NOT pay Income Tax, but passes through tax benefits, burdens and so on, to each owner. This income also increases the stated Tax Basis of the owners. Depending further analysis of the circumstances, the BOOK BASIS may increase too.

(This is an overly simplified method to provide general knowledge. Please seek advice from your CPA or tax accountant when making decisions or planning for your business).

Bottom line is, both you and your CPA, or Tax Accountant, needs to know your basis because:

  1. Your tax basis will determine (to an extent, as explained above) how much of the business’ losses are deductible.  If you don’t know how much basis you have in the business, you won’t know how much you are able to deduct.
  2. Your basis will determine the amount of gain or loss on sale of the business, partner share, or stock.
  1. Your annual Schedule K-1 often looks incorrect or inconsistent due to the changes made annually. If you have changed accountants over time, they may not have been calculating your basis correctly and applying the correct balances.

Your CPA or Tax Accountant should be involved throughout your ownership of every investment company to properly advice you on tax and accounting changes and how they will impact you on an individual level.

Sources:

Corporations, Partnerships, Estates and Trusts 2017 Edition. Authors: Hoffman, William; Raabe, WIlliam; Maloney, David; Young, James. Publisher: South-Western Cengage Pages: 14-4 to 14-8.

IRS.gov (2016). Publication 925. Retrieved July 24, 2017 from: https://www.irs.gov/publications/p925/ar02.html#en_US_2016_publink1000104595

Disclaimer:
This publication is designed to provide information of federal tax and accounting laws and/or regulations. It is presented with the understanding that the author is not rendering legal or accounting services.
This text is not intended to address every situation that arises or provide specific, strategic tax and/or accounting planning advice. This text should not be used solely to answer tax and/or accounting questions and you should consult additional sources of information, as needed, to determine the solution to tax and/or accounting questions.
This text has been prepared with due diligence. However, the possibility of mechanical or human error does exist and the author accepts no responsibility or liability regarding this material and its use. This text is not intended or written by the practitioner to be used and cannot be used by a taxpayer or tax return preparer, for the purpose of avoiding penalties that may be imposed.

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